Joint Credit Risk Management of Balance Sheet and Hedge Portfolio

Abstract:     
The concept of a treasury for credit risks is introduced by means of the analogy with the ''classic'' case, namely the interest rate risks' one. The ''classic'' treasury hedges interest rate risks of the banking book by oversteering them by means of an off-balance sheet portfolio consisting of interest risk sensitive assets. See Farinelli-Vanini (2008, 2006). The credit treasury hedges credit risks of the banking book by oversteering them via an off-balance sheet portfolio consisting of credit risk sensitive assets. As in the interest risk case, a full hedge (corresponding to an infinite risk aversion) will always generate a vanishing treasury P&L. By means of a model for spread structures with good predictive power, bets on credit risks at portfolio level are possible. In particular, one has to carefully take into account stochastic dependences over time as soon as there is an evidence of autocorrelations, which is the case if the treasury strategy requires frequent allocation reshufflings.

Number of Pages in PDF File: 31

Keywords: Balance and Off Balance Sheet, Portfolio Credit Risk, Dynamic Mean Variance Optimization

JEL Classification: G18, C19, G21, C69

working papers series